American Bar AssociationGeneral Practice, Solo, and Small Firm Division

The Compleat Lawyer, Summer 1996, Vol. 13, No. 3

Family Limited PartnershipsReducing estate and gift taxes

BY MICHAEL D. MULLIGAN

Michael D. Mulligan is a lawyer with Lewis, Rice & Fingersh, L.C., in St. Louis, Missouri.

The potential of limited partnerships to reduce the estate and gift tax value of assets has been apparent for some time. Now, families are increasingly using family limited partnerships (FLPs) to produce valuation discounts on assets such as marketable securities and shares of closely held corporations.

Interest in valuation discounts in general and family limited partnerships in particular increased significantly after the IRS issued Rev. Rul. 93-12, 1993-1 C.B. 202. In Rev. Rul. 93-12, the IRS abandoned its position that a minority interest discount is not available in valuing a minority interest in a closely held business if the decedent's or donor's family controls the business.

As a result of Rev. Rul. 93-12, the use of techniques that involve the bifurcation of control among several family members in order to produce valuation discounts has become more prevalent. Such bifurcation is easily accomplished with a closely held corporation constituting a family business. It is also possible to use an FLP to produce similar results with marketable securities.

The valuation reduction produced by FLPs can be substantial. In Watts, the partnership produced a discount of 35 percent. In Harrison, the discount was 45 percent. Both Watts and Harrison were estate tax cases. Similar discounts would be available for lifetime gifts of partnership interests.

The Limited PartnershipIn an ordinary partnership, all partners are personally liable for partnership debts. The limited partnership was originally developed to permit investments in a partnership form with limited liability. The potential liability of a limited partner for partnership debts is limited to the amount of his or her investment in the partnership. By law, a limited partner cannot participate in the management of the partnership (although, if a limited partner also holds a general partnership interest, he or she can participate in management as a general partner).

The law requires a limited partnership to have one or more general partners. A general partner is individually liable for partnership debts. Regardless of their percentage interest in the partnership, the general partners control the day-to-day management of the partnership. They, in turn, can delegate responsibility for management to a managing partner.

Although the limited partnership was originally designed as an investment device, it appears that the FLP can be used as an estate planning device to create estate and gift tax valuation discounts. Discounts can be produced because of the restrictions that the law governing limited partnerships places on partners, especially limited partners. (See "Maximizing Discounts." )

Reducing Estate and Gift Tax Value of Marketable SecuritiesSome commentators have questioned whether an FLP can be used to produce estate and gift tax valuation discounts for marketable securities. These commentators have raised the possibility that the courts might view an FLP holding only marketable securities as a sham, devoid of economic substance or a business purpose. (See Sheppard, Can the IRS Challenge Family Limited Partnerships?, 63 Tax Notes 1388 (June 13, 1994).)

However, some authorities indicate that an FLP should not be ignored as a sham solely because it holds only passive investments. In Harrison v. Commissioner, the court expressly rejected the IRS's argument that the existence of the FLP in that case should be ignored as an artificial attempt to depress the estate tax value of the real estate, oil, and gas interests and marketable securities held by the FLP.

The I.R.C. itself recognizes the existence of partnerships holding marketable securities. Under I.R.C. § 721(a), the transfer of appreciated property to a partnership in exchange for an interest in the partnership is normally a tax-free exchange. I.R.C. § 721(b) makes this general nonrecognition rule inapplicable to the transfer of appreciated property to a partnership holding more than 80 percent of the value of its assets (excluding cash and nonconvertible debt obligations) in readily marketable stocks or securities, if the transfer results in diversification of the transferor's interests. It is difficult to see how an FLP holding marketable securities is to be ignored as devoid of economic substance when I.R.C. § 721(b) could apply to tax gain on the transfer of assets to the FLP.

I.R.C. § 731(c) is an even stronger recognition of partnerships holding marketable securities. This statute provides that the distribution of marketable securities from a partnership to partners is generally to be treated as a distribution of money for purposes of determining whether the distribution is taxable to the partners. A so-called investment partnership is exempt from this general rule. The statute defines an investment partnership as a partnership that has never been engaged in a trade or business, and substantially all assets (by value) of which have always consisted of money, stock in a corporation, and similar holdings.

The IRS's own regulations appear to recognize the validity of partnerships holding marketable securities. The so-called Anti-abuse Regulations (Treas. Reg. § 1.701-2), issued at the end of 1994 and revised in early 1995, contain examples involving partnerships formed to engage in investment in securities (examples 5 and 9). The examples implicitly recognize the existence and validity of the partnerships.

In light of the above authorities, it would appear difficult for the IRS to argue that an FLP holding marketable securities is a sham. Although the matter is not immune from question, it appears that a partnership properly structured under applicable state law to consist of two or more persons joining together with the objective of engaging in investment activities should be recognized for federal estate and gift tax valuation purposes. There is no case or official IRS pronouncement to the contrary.

FLPs and Closely Held Corporate StockIn addition to marketable securities, a question arises of whether an FLP can also be used to produce valuation discounts for shares of closely held corporate stock. Some estate planners believe that FLPs can be used to layer entities to produce additional valuation discounts over the discounts available for the closely held stock. These practitioners suggest that the estate owner can retain the right to vote stock placed in the FLP either as managing partner or by holding a controlling portion of the general partnership interest in the FLP.

The retention of the right to vote shares of closely held stock poses potential difficulties under I.R.C. § 2036(b). That statute was enacted as a part of the Tax Reform Act of 1976 to overrule legislatively the Supreme Court's decision in United States v. Byrum (408 U.S. 125 (1972)). In Byrum, the decedent transferred stock of a closely held corporation to an irrevocable trust, reserving the right to vote the transferred shares. The Supreme Court held that the retained voting right did not cause the stock to be included in the decedent's federal gross estate.

Under I.R.C. § 2036(b), if an individual transfers stock of a controlled corporation but retains the right, directly or indirectly, to vote the transferred shares, such retention causes the transferred stock to be included in the transferor's gross estate for federal estate tax purposes. The result is that the shares are included in the transferor's federal gross estate as if the transfer had not taken place. A controlled corporation is a corporation in which the decedent, with application of the constructive ownership rules of I.R.C. § 318, is deemed at any time within three years of death to own or have the right to vote stock possessing at least 20 percent of the total combined voting power of all classes of stock.

Although there is no authority directly on this point, it seems that I.R.C. § 2036(b) is broad enough to cover a transferor's retained power as managing or general partner to vote shares of closely held stock transferred by the transferor to an FLP. The IRS could argue that I.R.C. § 2036(b) operates to cause the shares to be included in the transferor's estate directly, and that the registered owner of the shares is irrelevant. Under this reasoning, the strictures of the FLP would have no impact on the valuation of the shares in the transferor's estate. If an FLP is to be used with closely held stock to layer entities, it would seem wise to avoid the possible application of I.R.C. § 2036(b) by issuing nonvoting stock and placing the nonvoting stock in the FLP.

Lapses and Applicable Restrictions under I.R.C. § 2704I.R.C. § 2704(a) treats the lapse of a voting or liquidation right in a corporation or partnership as a taxable transfer for estate and gift tax purposes. If the statute applies, the amount of the transfer is the value of interests held by the transferor before the lapse over the value of such interests immediately after the lapse.

Under I.R.C. § 2704(b)(1), the estate or gift tax value of any transferred interest in a corporation or partnership is determined without regard to any "applicable restriction" on the transferred interest, so long as the transferor and members of the transferor's family control the entity immediately before the transfer. I.R.C. § 2704(b)(2) defines "applicable restriction" as any restriction that effectively eliminates the ability of the corporation or partnership to liquidate; and that lapses, in whole or in part, after the transfer; or that the transferor or any member of the transferor's family can remove, either in whole or in part. Under I.R.C. § 2704(b)(3), the term "applicable restriction" does not include any commercially reasonable restriction that arises as a part of any financing by the entity with a person who is not related to the transferor or transferee, or a member of the family of either, or any restriction imposed or required to be imposed by any federal or state law. Regulations under I.R.C. § 2704(b) establish an additional important exception to the definition of applicable restriction. Under Treas. Reg. § 25.2704-2(b), a restriction on the ability to liquidate is not an "applicable restriction" if the restriction is not more restrictive than the limitations that would apply under applicable state law in the absence of the restriction.

I.R.C. § 2704(a) and 2704(b) approach valuation issues presented by restrictions on voting and liquidation rights from opposite directions. Under I.R.C. § 2704(a), the lapse of a liquidation or voting right that reduces the value of an estate owner's holdings in an entity is treated as a transfer and subject to estate and gift tax. Under I.R.C. § 2704(b), restrictions that can be removed by the family unit are not recognized in determining the estate and gift tax value of interests subject to such restrictions.

Precluding Withdrawal by PartnerThe Revised Uniform Limited Partnership Act (RULPA) sections 602, 603, and 604 provide that in the absence of a provision in the partnership agreement, a partner may withdraw from a limited partnership and receive "fair value" for his or her interests in the partnership, presumably after any applicable minority interest and lack of marketability discounts. If applicable state law has adopted RULPA, it is necessary to override RULPA sections 602, 603, and 604 if an illiquidity discount is to be secured. For the discount to be secured, any override of RULPA sections 602, 603, and 604 must not constitute an applicable restriction that is ignored under I.R.C. § 2704(b).

Nonfamily member as a partner. A restriction is an applicable restriction under I.R.C. § 2704(b) only if the transferor or any member of the transferor's family has the right to remove the restriction. One method of avoiding I.R.C. § 2704(b) is to include a nonfamily member, e.g., a cooperating charity, as a partner, and require the consent of the nonfamily partner to any removal of the restriction. Thus, the partnership agreement might contain a provision prohibiting withdrawal by a partner, and require the consent of a nonfamily partner to the removal of that provision.

Selection of state law. Another method of precluding a limited partner from withdrawing without an applicable restriction is to take advantage of the state law exception of Treas. Reg. § 25.2704-2(b). Although RULPA as enacted in most states authorizes withdrawal by a limited partner unless there is a provision to the contrary in the partnership agreement, several states have adopted a different rule in their limited partnership statutes. For example, California, Colorado, Florida, Georgia, South Dakota, and Washington do not permit a limited partner to withdraw unless the partnership agreement allows withdrawal. Consideration might be given to forming the FLP under the law of a state that has such a rule. In light of Treas. Reg. § 25.2704-2(b), it can be anticipated that other states will change their limited partnership statutes and preclude withdrawal by a limited partner unless withdrawal is authorized by the partnership agreement.

In selecting the partnership law of another state, care must be taken to consider the possible adverse consequences of such a selection. For example, the State of Georgia used to have an intangibles tax that was payable annually. The tax rate was $1 for each $1,000 of value. The Intangibles Tax Division of the Georgia Department of Revenue took the position that the intangibles tax is due from any Georgia limited partnership whether or not the underlying assets are located within the state. However, this tax was recently repealed.

Use of assignee status. It appears possible to avoid an applicable restriction under I.R.C. § 2704(b) without including a nonfamily member as a partner or forming the FLP under the laws of a state that does not permit withdrawal by a limited partner unless authorized by the partnership agreement. This result may be possible because of the limitations that state law places on the transfer of interests in a limited partnership.

I.R.C. § 2704(b) applies to a restriction on a transferred interest. In most instances, the interest received by a transferee is identical to the interest that a transferor gives up. Such is not the case with respect to interests in a limited partnership.

In the absence of a contrary provision in the partnership agreement, a transferee receiving a general or limited partnership interest acquires so-called assignee status and does not become a partner unless admitted to the partnership by the other partners. (See RULPA sections 301 and 401.) A transferee for purposes of this rule includes both the recipient of a lifetime transfer and the personal representative or other successor in interest of a deceased partner. Under RULPA section 702, an assignee who has not satisfied the conditions of RULPA sections 301 or 401 is not a partner, and does not possess any of the rights of a partner other than the right to receive partnership distributions attributable to the assigned interest. In particular, the assignee is not a partner entitled to withdraw and receive "fair value" for the assignee's partnership interest under RULPA sections 602, 603, and 604.

It should be possible in the partnership agreement to provide that an assignee of a general or limited partner's interest is not to be admitted into the partnership unless he or she has satisfied conditions specified in the partnership agreement, which the assignee does not control. The partnership agreement might follow RULPA and provide for the admission of an assignee only upon the consent of all other partners. Such a provision should not constitute an applicable restriction under I.R.C. § 2704(b), because it is not more restrictive than the restrictions that would apply in the absence of the provision.

Avoiding I.R.C. § 2704(a) lapses. If the transfer of a limited partnership interest converts that interest into an assignee's interest and such conversion causes loss of the right to withdraw from the partnership, such loss would constitute a lapse under I.R.C. § 2704(a). Such a lapse would be treated as an additional transfer with respect to the loss of the right to withdraw. This additional transfer under I.R.C. § 2704(a) would defeat much of the benefit derived from using state partnership law to avoid an applicable restriction under I.R.C. § 2704(b).

It should be possible to avoid an I.R.C. § 2704(a) lapse by a provision in the partnership agreement precluding withdrawal by a limited partner. So long as a limited partner is not able to transfer a limited partnership interest to another but is limited to transferring only an assignee's interest, the restriction on a limited partner's withdrawal should not itself constitute an I.R.C. § 2704(b) applicable restriction. This is because the restriction does not apply to a transferred interest, but only to the interest held by the transferor. I.R.C. § 2704(b) applies to transferred interests. It thus appears possible to use the distinctions that state law creates between partner and assignee status to thread through I.R.C. § 2704 to avoid both applicable restrictions and lapses. Most state laws governing other entities, such as limited liability companies, do not afford the ability to avoid I.R.C. § 2704 in this fashion.

Sidebar: Maximizing Discounts

Although the authorities are not uniform and some are conflicting and confusing, there are at least three grounds for claiming valuation discounts with FLPs. Although interrelated, these three grounds are separate and distinct. Not all may be present in a particular case.

Types of discounts. One basis for valuation reduction is the so-called lack of marketability discount. This discount is allowed because there is no ready market for the interest being valued. The interest owner is not guaranteed ready access to a purchaser in the event that the owner wishes to sell the interest.

A second discount is a so-called minority interest discount. This discount is allowed when the owner of the interest does not control the entity in which the interest is held.

The third basis for valuation reduction is the discount allowed for illiquidity. This discount is similar to the lack of marketability discount. An illiquidity discount is allowed when the interest owner cannot compel the entity in which the interest is held to liquidate that interest.

Producing all three discounts. If the objective is to maximize value reduction, the FLP should be structured, if possible, to take advantage of all three discounts.

Under the Revised Uniform Limited Partnership Act (RULPA) as amended in 1985, which is in effect in many states, a limited partner is not permitted to participate in the management of the partnership. There is clearly no ready market for a limited partnership interest in a family controlled FLP. The absence of management control and the lack of marketability should produce minority interest and lack of marketability discounts. A question arises as to whether the FLP can be structured so as to produce an illiquidity discount. Any effort to obtain this discount must take I.R.C. § 2704 into account.

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